Tuesday, July 24, 2007

The Conundrum is simple and is this - the market continues to climb based on a "buy on the dips" mentality fed, at least in part, on continued takeover speculation that is embedded in the value of equities. Every time the market declines significantly, it bounces right back as investors jump into names they have been stalking. I think that at every buy side shop there is an investment thesis template that reads "potential buyout candidate" and all the analyst has to do is fill in the name and symbol, and give it to his Portfolio Manager.

However, the financing that supports that takeover activity is starting to undergo a repricing by investors based on a reevaluation of the perceived risk. Many investors have stopped investing at all here or have paused, while other investors are rejecting covenant lite and toggle or pay in kind bonds while demanding higher yields. Higher yields mean less of a return on these deals which will shrink the universe of potential buyout candidates.

There are at least 6 "hung up" bridge loans held by investment banks where Wall Street firms provided interim financing to buyout shops, in anticipation of replacing the bridge loan with permanent financing. Until this pipeline clears or the investment banks feel that conditions in the credit market are returning to normal (I hate to even use the word normal) this type of stop gap financing will be harder to come by.

The latest deal financing to fall through was reported today by The Wall Street Journal - the buyout of Allison Transmission, a unit of General Motors. Investment banks postponed an offering of $3.1 billion in loans.

We have a conundrum here. The stock market cannot continue to be propped up by the private equity buyout frenzy if the financing that supports that frenzy is no longer viable. There are a number of possibilities here:

1) The market is seeing through the current turmoil in the credit markets and expects the financing to return. If true, this would be extraordinary considering the market usually has a one-week time horizon.

2) The market believes that even if risk reprices at a higher level - the internal rate of return (IRR) on private equity deals will still be sufficient enough that the buyouts will continue.

3) There are other things that are pushing the market higher besides the buyout frenzy. This could be a number of things, perhaps even the dreaded "liquidity" excuse that I hate so much as OPEC and the Chinese have so much money they have to put it somewhere.

4) I am completely wrong and have no idea what I am talking about and shouldn't be writing an investment blog much less running a hedge fund. If this is true please send me an e-mail privately and tell me.

5) The investors who are propping the market up don't fully understand the reasons supporting valuation that I described earlier in this post so therefore they cannot stop investing when these reasons end.

6) There is a lag time before the financing problems impact the stock market.

7) Investors believe that private equity shops have so much money that they will spend it no matter what. If they make bad deals it will be years before the limited partners who invest in these funds feel it.

If I had to make a bet, it would be on reasons 2 and 7 (I hope it's not #4). Interest rates are still low historically, some marginal deals may fall through, but many would still work at least on paper based on a spreadsheet with optimistic projections of future cash flow growth and EBITDA exit multiples.

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